What is the Difference Between Chit Funds vs Mutual Funds?
Investing played a significant role in shaping the course of history, with its roots tracing back centuries. Amongst the popular schemes, chit funds and mutual funds have been popular saving sources for many Indians. In India, chit funds, also known as “chitragupta” or “kuri,” have been an integral part of the financial landscape for over 200 years. Rooted in small communities and cultures, it remains a means of credit for many and is regulated by a chit fund company.
Hence, investors are highly favourable to these two investment options and often compare them due to their similar functioning. Therefore, in this blog, we will understand how chit funds and mutual funds work in a financial ecosystem and the major differences between chit funds vs mutual funds.
What is a Chit Fund?
Chit fund is an investment scheme that was initially established to provide a means of credit to small traders and merchants who lacked access to traditional banking services. Thus, in this type of financial arrangement, a group of individuals come together to contribute fixed amounts of money regularly into a common pool.
The participants, often referred to as subscribers or members, enter into an agreement with a chit fund company or organizer to form a chit-fund group. The primary purpose of a chit fund is to provide a savings and borrowing mechanism for its members. The concept of chit funds was prevalent in other parts of the world too. This includes Greece and Rome, where they were used to finance trade and maritime expeditions. Thus, with the advent of progress and awareness, people have started investing in government chit fund companies for safe trade.
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from multiple investors to invest in a diversified portfolio of securities. These securities include bonds, stocks, equity funds, debt funds, and sector-specific funds. It is managed by professional fund managers who make investment decisions on behalf of the investors. The investors, also known as unit holders, purchase units of the mutual fund, which represent their proportional ownership in the fund’s assets.
Chit Fund vs Mutual Fund
Despite their similar functioning, the differences between chit funds vs mutual funds are the debate in India. Let’s have a look at some of the differences first.
|Parameters||Chit Funds||Mutual Funds|
|Structure||Group of individuals contributing fixed amounts regularly into a common pool||The pool of money collected from multiple investors to invest in a diversified portfolio of securities|
|Objective||Savings and borrowing mechanism, facilitating access to funds and credit||Long-term wealth accumulation, capital appreciation, and achieving specific financial goals|
|Management||Typically managed by chit fund companies or organizers||Professionally managed by fund managers|
|Returns||Depend on the bidding process, with the potential for higher returns for the winner of the auction||Returns are linked to the performance of the underlying securities and market conditions|
|Risk||Relies on the reliability and integrity of the organizer and group members||Subject to market risks associated with the performance of the securities|
|Liquidity||Withdrawal before the tenure ends may not be easy or possible||Generally more liquid, allowing you to buy or sell units at the fund’s NAV on any business day|
|Diversification||Limited diversification, as the funds depend on the contributions of a limited number of participants||Provides diversification by investing in a range of securities, spreading risk across asset classes|
|Regulatory Oversight||Varies by country and jurisdiction||Regulated by financial authorities and subject to compliance with regulatory requirements|
|Investment Duration||Fixed duration for each chit fund cycle, determined by the group||No fixed duration, investors can stay invested for the desired period|
|Investment Size||Contributions can be flexible, determined by the agreement among the members||You can start with small amounts and choose investment options based on financial capacity|
|Accessibility||Preferred by individuals with limited access to formal banking services||Accessible to individuals through various channels, including banks, financial institutions, and online platform|
How Does the Chit Fund Scheme Work?
Let’s say a chit fund group consists of 20 members, and they decide to contribute INR 10,000 each per month. Thus, the duration of the chit fund cycle is set to 20 months.
In the first month, the total contribution to the chit fund pool would be INR 2,00,000 (INR 10,000 x 20 members). The organizer conducts an auction or draws to determine which member will receive this amount.
For instance, Member A bids a discount of INR 5,000 on the total contribution, Member B bids a discount of INR 6,000, Member C bids a discount of INR 7,000, and so on. The lowest unique bidder, let’s say Member E, with a discount of INR 9,000, wins the auction.
Member E would then receive INR 1,91,000 (INR 2,00,000 – INR 9,000) as the payout, while the remaining INR 9,000 would be divided equally among the other members.
The process continues each month for the duration of the chit fund cycle. Each month, a different member would be selected as the winner of the auction until all members have received their turn to receive the lump sum payout.
How Do Mutual Funds Work?
Unlike chit funds, mutual funds pool money from different investors to invest the amount in stocks instead of giving a lumpsum amount to a particular investor. Your preferred AMCs allocate units of mutual funds to you. In certain stocks, your money invested may generate returns thereafter. SEBI (Securities and Exchange Board of India) regulates all your transactions, making your investment trustworthy, unlike chit funds.
What are the Popular Chit Funds in India?
Let’s have a look at some of the popular chit funds in India.
- Mysore Sales International – Government of Karnataka
- Kerala State Finance Enterprises – Government of Karnataka
- Shriram Chits – Shriram Group
- Margadarshi Chit Fund Private Limited – Ramoji Rao Group
What are the Types of Mutual Funds?
Here is a list of types of mutual funds that you must know about. Thus, we have mentioned them as follows:
- Equity Funds: Invest in stocks and aim for capital appreciation over the long term.
- Debt Funds: Primarily invest in fixed-income securities like bonds and provide regular income.
- Balanced Funds: Maintain a mix of stocks and bonds to offer a balance between growth and income.
- Index Funds: Aim to replicate the performance of a specific market index, providing broad market exposure.
- Sector-Specific Funds: Concentrate investments in a particular industry or sector to capitalize on its growth potential.
What are the Types of Chit Funds?
The classification of chit funds may vary based on local laws and regulations in different jurisdictions. Thus, some of the general categories are mentioned below:
- Special Purpose Chit Funds: These chit fund schemes are formed with a specific objective in mind, such as funding a particular project or meeting a specific financial need. They cater to individuals who have a common purpose or goal and come together to pool their resources accordingly.
- Organized Chit Funds: Organized chit funds are professionally managed and regulated by chit fund companies or organizers. They operate within the legal framework and comply with the necessary rules and regulations set by the governing authorities. This provides them a structured and secure environment for participants.
- Online Chit Funds: With the advent of technology, online chit funds have emerged, enabling participants to engage in chit fund activities through digital platforms. These platforms facilitate the online management of chit fund operations, including contributions, auctions, and payouts, providing convenience and accessibility to participants.
- Registered Chit Funds: Registered chit funds are those that comply with legal requirements. Also that register with the relevant regulatory authorities. Thus, they offer transparency, accountability, and investor protection, as they operate within the framework of the law, following specific guidelines and regulations.
- Unregistered Chit Funds: Unregistered chit funds, as the name suggests, do not comply with the regulatory requirements or register with the appropriate authorities. They operate outside the legal framework and may pose higher risks to participants, as they lack oversight and regulatory safeguards.
What are the Factors to Consider Before Investing in Chit Funds vs Mutual Funds?
Till now, we have covered some of the basics between chit funds vs mutual funds. Thus, now it’s time to review the factors that you must consider before investing in these two funds.
- Risk Tolerance: Consider your risk tolerance and comfort level with different types of investments. Mutual funds offer varying risk profiles based on their asset allocation, while chit funds carry a different set of risks related to the reliability of the group members.
- Investment Goals: Determine your investment goals, whether they are long-term wealth accumulation, regular savings, or specific financial targets. Mutual funds provide opportunities for capital appreciation, while chit funds focus on savings and potential lump sum payouts.
- Time Horizon: Evaluate your investment time horizon. Long-term investments are better suited for mutual funds, which allow the potential for compounded growth. Chit funds usually have a fixed tenure, and it’s important to align the tenure with your specific financial goals.
- Diversification Needs: Assess your diversification requirements. Mutual funds offer diversification by investing in a broad range of securities, spreading risk across various asset classes. Chit funds primarily rely on contributions from a limited number of participants, which may not offer the same level of diversification.
- Professional Management vs Self-Management: Professionals manage mutual funds and make investment decisions on your behalf. Chit funds require active participation and decision-making from the group members themselves. Choose an option that aligns with your comfort level and available time for investment management.
Should You Invest in Chit funds?
India has been a host to many chit funds. There have been instances where people have fled with the investor’s money with no sign of coming back.
However, in some cases, chit funds have served as a sole and last resort for people who need money but are often overlooked by banks and other financial institutions. These especially include people belonging to small towns and villages.
‘Despite several frauds, chits remain ubiquitous in every nook and cranny of the country due to their ease of operation and need. Therefore, those who have other investments and savings sources can avoid chit funds.’ says Subba Rao Anupindi, a senior CA and financial planner.
Which is the Better Option – Mutual Funds or Chit Funds?
Mutual funds are professionally managed investment vehicles that are regulated by SEBI and may deliver returns to all stakeholders instead of one subscriber like chit funds. However, for some people, chit funds may be a better option, especially for those who want to get a lump sum amount by paying just a small amount first.
Additionally, due to the rise in literacy rates, people are definitely inclined towards more streamlined ways like the stock market, MFs, and others. But the emotional connectivity between small towns and chit funds cannot be ignored either.
Thus, there is no concrete answer as to which is a better option: chit funds vs mutual funds. Ultimately, the choice between mutual funds and chit funds depends on your factors. These factors include specific financial situation, investment goals, risk appetite, and access to financial services. Therefore, it’s advisable to assess your requirements and consult with a financial advisor.
To Wrap It Up…
Despite their similar functioning, the difference between chit funds and mutual funds is quite visible. Likewise, they carry similar returns and risk profiles. However, since SEBI regulates mutual funds by providing diversification to reduce the overall risk of investment, chit funds are prone to scams.
Thus, it is advisable to consult your financial advisor before investing in chit funds vs mutual funds. At an individual level, one should consider the credibility and creditworthiness of the company and the fund’s promoters.